Homepage / Currency / The case against shrinking the Fed’s balance-sheet
Amazon says this Prime Day was its biggest shopping event ever Kudlow says President Trump is 'so dissatisfied' with China trade talks that he is keeping the pressure on As stocks regain their footing, an ominous warning looms Goldman Sachs downgrades Clorox to sell, says valuation is 'unsustainably high' How Satya Nadella has spurred a tripling of Microsoft's stock price in just over four years Kudlow says economic growth could top 4% for 'a quarter or two,' more tax cuts could be coming The one chart that explains Netflix’s stunning comeback US housing starts plunge 12% in June to a nine-month low Aerospace titans Boeing and Airbus top $110 billion in orders at Farnborough Target uses Prime Day to its advantage, logging its 'biggest online shopping day' so far this year Billionaire Marc Lasry sees bitcoin reaching up to $40,000 as it becomes more mainstream and easier to trade These are the 10 US airports where you're most likely to be hacked Amazon shares slightly higher as investors await Prime Day results Wreck of Russian warship found, believed to hold gold worth $130 billion A bullish ‘phenomenon’ in bond market is weeks away from fading, top credit strategist says Stocks making the biggest moves premarket: MS, GOOGL, TXN, UAL, NFLX & more Twitter shares up 50% since late April means most upside priced in, analyst says in downgrade EU fines Google $5 billion over Android antitrust abuse Mortgage applications fall 2.5% as buyers struggle to find affordable homes America may not have the tools to counter the next financial crisis, warn Bernanke, Geithner and Paulson Investors are getting spooked as the risk of a no-deal Brexit rises EU expected to fine Google $5 billion over Android antitrust abuse Ex-FBI chief James Comey urges Americans to vote for Democrats in midterm elections Elon Musk apologizes to British cave diver following baseless 'pedo guy' claim Disney, Comcast and Fox: All you need to know about one of the biggest media battles ever Xiaomi shares notch new high after Hong Kong, mainland China stock exchanges reach agreement The trade war is complicating China's efforts to fix its economy European markets set for a strong open amid earnings; Google in focus Hedge fund billionaire Einhorn places sixth in major poker tournament The biggest spender of political ads on Facebook? President Trump Asian stocks poised to gain after Fed's Powell gives upbeat comments; dollar firmer Stocks are setting up to break to new highs Not all FAANG stocks are created equal EU ruling may be too little, too late to stop Google's mobile dominance Cramer explains how Netflix's stock managed to taper its drop after disappointing on earnings Airbnb condemns New York City's 'bellhop politics,' threatens legal retaliation Amazon sellers say they were unfairly suspended right before Prime Day, and now have two bad choices Investor explains why 'duller' tech stocks can have better returns than 'high-flying' tech names Elon Musk is 'thin-skinned and short-tempered,' says tech VC Texas Instruments CEO Brian Crutcher resigns for violating code of conduct Google Cloud Platform fixes issues that took down Spotify, Snapchat and other popular sites Uber exec: We want to become the 'one stop' transportation app 'What a dumb hearing,' says Democrat as Congress grills tech companies on conservative bias Amazon shares rebound, report says Prime Day sales jumped 89 percent in first 12 hours of the event How to put your medical history on your iPhone in less than 5 minutes Investment chief: Watch these two big events in 2018 Even with Netflix slowing, the market rally is likely not over Cramer: Netflix subscriber weakness debunks the 'sky's the limit' theory on the stock Netflix is looking at watch time as a new area of growth, but the competition is stiff Why Nobel laureate Richard Thaler follows Warren Buffett's advice to avoid bitcoin Rolls-Royce is developing tiny 'cockroach' robots to crawl in and fix airplane engines After Netflix plunge, Wall Street analysts forecast just tame returns ahead for the once high-flying FANG group Roku shares rise after analyst raises streaming video company's price target due to customer growth China is investing 9 times more into Europe than into North America, report reveals Amazon says US Prime Day sales 'so far bigger than ever' as glitch is resolved Netflix is on pace for its worst day in two years US lumber producers see huge opportunity, rush to expand San Francisco to consider tax on companies to help homeless Homebuilder sentiment, still high, stalls as tariffs, labor and land drive up costs Powell backs more rate hikes as economy growing 'considerably stronger' Netflix history is filled with big stock declines – like today – followed by bigger rebounds Intel shares get downgraded by Evercore ISI due to rising competition from Nvidia, AMD Petco aims to reinvent the pet store with something you can't buy online Genetic testing is coming of age, but for consumers it's buyer beware Tech 'FAANG' was the most-crowded trade in the world heading into the Netflix implosion, survey shows Netflix weak subscriber growth may indicate a 'maturity wall' that could whack the stock even more: Analyst This chart may be predicting the bull market's demise Wall Street says Netflix's stock plunge is a ‘compelling’ buying opportunity because the streaming giant ‘never misses twice’ Tesla sinks after Musk tweets, again Boeing announces new division devoted to flying taxis Stocks making the biggest move premarket: NFLX, UNH, GS, AMZN, WMT & more Deutsche Bank downgrades Netflix, but says big subscriber miss is not 'thesis changing' IBM is experimenting with a cryptocurrency that’s pegged to the US dollar North Korea and Zimbabwe: A friendship explained Virgin Galactic spinoff Orbit to launch rockets from the UK with space deal Artificial intelligence will create more jobs than it destroys? That’s what PwC says ‘Treasonous’ Trump and ‘Putin’s poodle:' Scathing headlines follow the Trump-Putin summit China’s fintech companies offer ‘enormous’ opportunity, investment manager says Trump's performance at summit with Putin was 'unprecedented,' experts say Walmart and Microsoft link up on cloud technology as they both battle Amazon European stocks seen mixed amid earnings; Fed’s Powell to address Congress How I knew I should quit my day job and run my start-up full-time: Viral website founder China's stocks have been trounced, but the trade war may ultimately be good news for those shares Billionaire tech investor Peter Thiel bets on crypto start-up Block.one Asian shares subdued open after mixed close on Wall Street; energy stocks under pressure Amazon cloud hits snags after Amazon Prime Day downtime Netflix isn't doomed by one quarter unless people start questioning the long-term investor thesis Tech stocks set to sink on Tuesday after rough evening for ‘FANG’ Netflix plummets after missing big on subscriber growth This wristband lets humans control machines with their minds The U.S. has a rocky history convincing Russia to extradite computer criminals Amazon suffers glitches at the start of Prime Day Jeff Bezos is now the richest man in modern history 'The United States has been foolish': Read Trump and Putin's full exchange Goldman Sachs recommends these 5 highly profitable companies — including Nvidia — to combat rising inflation Goldman Sachs releases 'tactical' stock picks for this earnings season Three red flags for Netflix ahead of its earnings report The bond market may be raising recession fears, but don't expect one anytime soon Cramer: Banks are 'making fortunes' but are still as hated as they were during the financial crisis Putin told Trump at summit: Russia never meddled in US election

Currency

The case against shrinking the Fed’s balance-sheet

AS EXPECTED, the Federal Reserve announced on September 20th that it will soon begin reversing the asset purchases it made during and after the financial crisis. From October, America’s central bank will stop reinvesting all of the money it receives when its assets start to mature. As a result, its $4.5trn balance-sheet will gradually shrink. However, the Fed did not give any clues as to what the endpoint for the balance-sheet should be. This is an important question. There are strong arguments for keeping the balance-sheet large. In fact, it might be better were the Fed not shedding any assets at all. 

Most commentators view a large balance-sheet, which is the result of quantitative easing (QE), as an extraordinary economic stimulus. Janet Yellen, the Fed’s chair, seems to agree: at a press conference after the Fed announcement, she said the balance-sheet should shrink because the stimulus it provides to the economy is no longer needed. But the claim that the balance-sheet is stimulating the economy is far from an established fact. The theoretical case for it is weak (Ben Bernanke, Mrs Yellen’s predecessor, famously quipped that QE “works in practice, but it doesn’t work in theory”). While most studies have shown that QE brought down long-term interest rates, it may have worked by signalling that the central bank was serious about keeping rates low for a long time, or by lubricating financial markets during the credit crunch. If so, the Fed’s balance-sheet is probably not providing much stimulus to the economy today. Markets have not seemed to react much the Fed’s signals that today’s announcement was coming (see article). 

  • The case against shrinking the Fed’s balance-sheet

  • Can companies block employees’ class-action lawsuits?

  • Kenya’s supreme court explains why it annulled last month’s presidential poll

  • Tadeusz Kosciuszko, Poland’s all-American hero

  • Toys “R” Us files for bankruptcy

  • Modern slavery is disturbingly common

How, then, should we think about the right size for the balance-sheet? An alternative way of viewing QE is as an operation that changes the maturity profile of government debt. The Fed hoovers up Treasury bonds, and replaces them with newly-created bank reserves. Those reserves are just a different type of government liability. Just as the Treasury pays interest on bonds it has issued, the Fed pays interest on bank reserves. The Fed and the Treasury both, in practice, represent the same borrower: the federal government. The main difference between the two types of debt is that Fed reserves are perpetual and instantaneously redeemable—in other words, they are money. Treasuries, by contrast, mature at a known date (though their liquidity and safety makes them resemble money). 

The best size for the Fed’s balance-sheet therefore depends on the best maturity profile for government debt, once the liabilities of the Fed and the Treasury have been combined. If money is more useful than Treasury bills, then the Fed performs a useful service by swapping one for the other. And money is useful. In a paper from 2016, Robin Greenwood, Samuel Hanson and Jeremy Stein argue that abundant bank reserves increase financial stability. They note rampant demand in financial markets for money-like instruments: from 1983 to 2009 one-week Treasury bills yielded, on average, fully 72 basis points less than six-month bills. (For comparison, the difference in yield between a five-year Treasury and a ten-year one is below 50 basis points).

The authors argue that when the government fails to satisfy this demand, the private sector steps in, by issuing very short-term debt like asset-backed commercial paper. This threatens financial stability, because such debt tends to be risky. A run on money-market funds, which had gorged on short-term private debt, was central to the meltdown in financial markets in late 2008.

So why not create plentiful reserves to fulfil the demand for money? One problem is interest-rate risk.  The shorter the maturity profile of government debt, the more painful an unexpected rise in interest rates would be for taxpayers. In practice, this works as follows. To raise interest rates, the Fed must immediately pay more interest on the reserves it has created. Yet it would not receive higher yields on the Treasury securities it owns. So an unexpected rise in interest rates could ultimately threaten the solvency of a central bank with a large balance-sheet. The taxpayer would have to plug the gap.

One solution to this problem, discussed by the authors, is a so-called “barbell” structure for government debt. This means a combination of very short-term liabilities, with the associated benefits for financial markets, and very long-term debt, which guards against interest-rate risk. The Fed could implement a barbell structure by buying up medium-dated Treasury bonds, thereby taking them out of the hands of the public. (This is probably better than the Treasury implementing a barbell structure on its own, because short-term Treasuries, unlike reserves, must be reissued frequently at auction.)

Unfortunately, the Fed is unlikely to give such considerations much weight. Its large balance-sheet is controversial. Many observers fail to see that its liabilities are another form of government debt, claiming instead that they “distort” the market for Treasuries. Similarly, The Fed’s critics claim the interest it pays on reserves constitutes a subsidy to banks. They fail to note that if banks held Treasuries instead, they would earn interest on those, too.

The political power of these worries will help determine the end point for the Fed’s balance-sheet. The Fed will need more assets than it did before the financial crisis, because of increased demand for currency, another central bank liability. There is currently $1.5trn of currency in circulation, up from about $800bn before the financial crisis. Keeping the current system for setting interest rates, which works by saturating banks with reserves and then paying interest on them, would probably require another $1trn of assets. However, the Fed might revert to the system it used before QE, when it controlled rates by keeping reserves scarce and tweaking their supply.

Which system is used, and hence the ultimate size of the balance-sheet, is a decision that will probably be taken after President Donald Trump decides whether or not to reappoint Mrs Yellen as chair. It is an important one. Economists since Milton Friedman have noted the benefits of interest-bearing money like bank reserves. The Fed should make sure there is lots of it about.

NextIs there a wage growth puzzle in America?

Source: economist
The case against shrinking the Fed’s balance-sheet

Comments are closed.